Inflation is slowing, but it’s still too high for the Fed
High inflation has been the big economic story over the past couple of years. Consumer demand surged after the economy started to reopen following the worst of the pandemic, supported by stimulus aid to households and rock-bottom interest rates, courtesy of the Federal Reserve.
At the same time, supply chain problems led to shortages of goods and services.
The result was the strongest inflation in four decades — something many Americans had never experienced before. But the picture has changed over the past year, with inflation gradually easing since 2022. It is still higher than it was before the pandemic, and is still too high for the Federal Reserve. But it appears that inflation will return to the Fed’s 2% objective over the next year, with limited damage to the U.S. economy.
Inflation is when consumer prices in the economy, broadly, are going up. At any point in time some prices are increasing, some prices are falling, and some are steady. But if prices are going up for most of the goods and services that households buy, the economy is experiencing inflation.
Although consumers most often focus on goods prices ( gasoline, food, clothes, appliances), services prices (education, health care, housing, recreation) make up a bigger chunk of consumer spending and are more important for measured inflation. The Federal Reserve is charged by Congress with achieving both maximum employment and price stability, which the central bank has defined as annual inflation of 2% over the long run.
The Fed aims for 2% inflation because it believes that this level of modest inflation is best for long-run economic growth and a strong labor market. Also, the Fed believes that with inflation of 2%, consumers and businesses can generally ignore price changes when making economic decisions.
That most assuredly has not been the case over the past few years.
Household spending plummeted in early 2020 as the pandemic came to the U.S. and consumers stayed home and millions lost their jobs. Then, spending surged in the second half of 2020 and in 2021 as the economy gradually reopened, the labor market recovered, stimulus payments filled consumers’ bank accounts, and recordlow interest rates supported purchases of big-ticket items like furniture and appliances.
In fact, goods purchases in late 2021 were about 16% higher, before adjusting for higher prices, than they were before the pandemic.
At the same time the pandemic caused all sorts of disruptions in supply chains, and producers were unable to keep up with surging demand. This led to shortages of many goods, with businesses passing along higher input costs and raising prices to take advantage of constrained supplies. In addition, the Russian invasion of Ukraine in early 2022 led to much higher energy prices.
As a result, inflation soared in 2021 and 2022. According to the consumer price index, inflation went from averaging less than 2% through the decade ending in 2019 to 7.2% in 2021 and 6.4% in 2022 — the highest inflation since the early 1980s. This left many consumers upset, particularly as wages were not keeping up with prices.
But the recent news on the inflation front has been much better.
Prices still went up in 2023, but at a much slower pace, with inflation of 3.3% over the year (see Chart).
In addition, wages continued to solidly increase. So after adjusting for inflation, wages in 2023 were higher than they were in 2022.
Energy prices fell over the course of 2023, food and beverage inflation slowed dramatically, and prices for goods excluding food and energy were essentially flat last year, returning to a prepandemic trend.
However, core services inflation (services excluding food and energy) remained elevated, although it did slow somewhat from the previous two years. This type of inflation is worrisome for the Federal Reserve because it’s driven in large part by wages, and is also sticky — once it’s embedded in the economy, it can be tough to wring out.
This is a big reason why the Fed is keeping the fed funds rate, its key policy interest rate, elevated in the near term. The Fed wants to see a bit slower growth in both jobs and wages that would help push inflation down. Further relief should come from the housing component of CPI, which is based on rents; rent growth slowed dramatically in 2023, and that should gradually work its way into the CPI because of the way the numbers are calculated.
The central bank has set an inflation objective of 2% using a slightly different measure than the CPI, the personal consumption expenditures price index. Thesetwo measures move in tandem, however, and the PCE price index has also slowed dramatically over the past couple of years, although it remains well above 2%.
The good news is that between slower rent growth and a continued easing in the labor market, inflation should be back down to 2% later this year.
This does not mean that prices are going to return to their pre-pandemic level: that would require a significant recession, which no one wants.
But inflation is soon set to return to the point where it won’t be top-of-mind for most households.